Debt deals endorse 'Chain CPI' to tamp down COLAS

Tuesday

Jul 26, 2011 at 12:01 AMSep 10, 2014 at 10:24 AM

Military retirees, social security recipients and others drawing federal payments were tempted to grumble at Congress or the White House when the past two Januarys brought no cost-of-living adjustment.The real culprits were a deeply distressed economy,

Military retirees, social security recipients and others drawing federal payments were tempted to grumble at Congress or the White House when the past two Januarys brought no cost-of-living adjustment.

The real culprits were a deeply distressed economy, which drove prices down, and a logical process, set up 40 years ago, to track inflation and adjust federal payments to protect their purchasing power.

Those who did complain about absent COLAs might soon have a more legitimate reason to grouse: a new yardstick for setting COLAs called the Chain Consumer Price Index for All Urban Consumers (or C-CPI-U)

First, let's review why COLAs stopped for two years.

Starting in the last quarter of 2008, the cost of goods and services fell sharply while housing and financial markets collapsed. Yet the last COLA, of January 2009, had been shaped by price data collected months earlier after gasoline prices had hit new highs. So federal entitlements jumped 5.8 percent, the largest bump in 25 years, as prices slid across the marketplace.

The tool long used by the Bureau of Labor Statistics to track inflation and set COLAs is the Consumer Price Index of All Urban Wage Earners and Clerical Workers (CPI-W). After the 2009 increase, no COLA could be paid until prices for a market basket of good and services surpassed levels reported in the third quarter of 2008, and used to set the 5.8 percent COLA.

The CPI-W only cleared that milestone in January 2011. Through June this year, CPI-W shows retirees in line for at least a 3.2 percent COLA next January, with inflation from July through September still to be measured.

For traditional indices like the CPI-W, BLS creates a market basket, using spending patterns for the covered population, and tracks inflation over time based on the overall change in the price of the basket.

The knock on such indices is that they overstate inflation through "substitution bias," ignoring how consumers respond to price changes. For example, if a family spent $100 last month on beef and the price doubles, their cost-of-living won't actually rise by $100, economists contend. Instead the family will buy less beef and more of something else like chicken.

CPI-W assumes consumers buy the same basket of goods regardless of price. Critics say it fails to capture behavioral changes that soften the blow of higher prices through purchase of relatively cheaper goods.

This issue surfaced 15 years ago in a study of the CPI known as the Boskin Commission report. Since then BLS changed how it calculates CPI-W and another index, CPI-U, which is used to adjust tax brackets and poverty thresholds. But the BLS changes could only address substitution bias within product categories, to capture how consumers might buy more of a regional brand of hot dog versus a more popular national brand.

Economists say CPI-W and CPI-U still ignore "upper level substitution" which occurs across product category, as when consumers decide to buy more apples when the price of oranges rises.

The C-CPI-U, which BLS established in 2002, addresses this, tracking not only prices but changes to a representative market basket month to month. It then "chains" months together to calculate overall cost of living.

Adopting the Chain CPI to adjust entitlements has been recommended by every group looking for ways to address the federal debt crisis. That includes two bipartisan commission reports from last winter; Vice President Joe Biden's debt-relief working group of Republicans and Democrats, and the "Gang of Six" senators whose blueprint for combining spending cuts and tax increases won an enthusiastic nod this week from President Obama.

Besides providing a more accurate measure of inflation, the C-CPI-U would save roughly $300 billion on entitlement spending over just the first decade after it took effect. It has its critics, however. They argue the Chain COLA ignores the fact that quality of life is impacted if consumers replace products they prefer with products they can better afford.

For individual federal retirees and social security recipients, the Chain CPI would dampen current COLAs an average of .25 to .3 of a percentage point per year. If we assume over time CPI-W will show a 3 percent inflation rate, the C-CPI-U would be 2.7 percent to 2.75 percent. That difference is expected to grow more pronounced over time.

Let's look at how a .3 percent difference would impact a retiree receiving retired pay of $2000 a month. With a 3 percent COLA, retired pay would climb the first year to $2060 a month versus $2054 with a 2.7 percent adjustment. After 10 years, the retiree would be drawing $2687.83 a month using CPI-W but only $2610.56 using C-CPI-U. The $6-a-month difference after a year becomes a difference of $77.27 a month over decade.

BLS itself doesn't endorse using one index over another for adjusting federal entitlements. But Steve Reed, a BLS economist, helped put perceived strengths and weaknesses in perspective.

"Economic theory certainly suggests that demand for a particular good is related to price. As price goes up, compared to other goods, we tend to demand less of it," Reed said.

The Chain CPI strives to capture the impact of substitution across product categories, Reed explained. It does so by measuring actual expenditures more often and readjusting the weighting of products and services in the consumer's market basket.

"The weight arguably could be said to be more accurate because it is mostly free of substitution bias," Reed said.

Expenditure data to support the Chain CPI isn't available immediately however. BLS month-to-month can only make estimates and the index must be revised twice before it becomes final two years after initial publication. Critics contend that makes the Chain CPI unsuitable for setting COLAs.

Ken Stewart, another economist at BLS, said any legislation to move to the Chain CPI for adjusting COLAs "would have to have a mechanism for how those revisions would be handled."